Strong Tobacco Stocks Valuations May Mask Future Concerns

You have to use different metrics to value tobacco stocks. They're not a 'normal' consumer cyclical: They're addictive.

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MINYANVILLE ORIGINAL Growth rate expectations and valuations are tougher to assess with tobacco stocks than other stocks in the consumer staples sector. One big problem that is never talked about is that elasticity of demand isn't as closely tied to price increases or decreases as it is with other products. With cigarette, elasticity takes longer to appear than just the next quarter. That is because the product is addictive; changes in consumer behavior take longer to show themselves. That is an important consideration at a time when other branded consumer packaged goods are showing possibly unprecedented demand elasticity and tobacco stocks have been held out as relatively safe havens in the consumer staples area.

The other problem in my opinion is that, obviously, nobody has to smoke, and that makes for more questionable long-term demand and margin expectations. High unemployment among the younger generations and lower-skilled workers (groups who disproportionately would be smokers) makes it is more costly for new teenaged customers to smoke or for current smokers to afford higher priced brands.

I saw a TV advertisement for a Hyundai Elantra trying to sell the car as a really cool ride for the 18-25 guys. While selling that ride obviously won't work with the intended targets, the very fact that Hyundai's marketers tried this audience shows the economic pressure that this group is under and brought home the kinds of unprecedented choices that this demographic group will increasingly be making.

The incidence of youth smoking as traced by three different surveys fell from 9%-20% in 2008 to 8%-19% in 2011, continuing a prior in-place downward trend of about a decade. [Editor's note: All three surveys showed declines; one is consistently high and the other two always show lower percentage changes.] Net pricing increases per pack in the US have been steadily coming down since mid-2009, about one year after the recession started in 2008. Operating income growth per pack of cigarettes has been trending down from 2009 as well, and is around 5% now.

Some observers think that the pricing increases on a per-pack basis could go up, if the domestic industry stopped trying to promote new -- and in some cases, lower -- priced brands. I think that the backdrop described above makes that thesis a poor bet, and that demand could get worse than the present 3.5%-4% per year decline in sales, albeit over a one-to-two year period (allowing for addictiveness again).

My best industry expectation would be a 4% per year unit decline over a five-year period. Pricing per pack is most recently in the 2.5%-4.5% range among different manufacturers, and I will assume an industry 4% price increase per year, somewhat above in years one and year, and below in years four and five. Therefore, units and prices cancel each other out for a near zero revenue expectation. Leaf prices will decline, but there will be increasing diseconomies of scale against selling general and administrative expense. Debt pay downs and share buybacks will be the biggest part of increasing earnings per share, or EPS. I am not explicitly factoring in any more acceleration in trade down to cheaper brands, which is possible. EPS growth could be 3%-4% for Reynolds (RAI), 5%-6% for Altria (MO), and 6% or more for Lorillard (LO).

Another unknown is the terminal growth rate. Other consumer staples industries are easy; for example, increases in food approximate population growth. Unless a new nicotine delivery system is approved by the Feds, ten or more years from now EPS changes are likely to be negative -- and just how negative, I believe, no one has a good handle on. Using Reynolds as an example, the difference between a 0% and a 2% negative terminal growth rate is $3 or 7% of its valuation.

Using a 4% risk free rate and a 6% risk discount for a US tobacco stock (vs. 4% for other consumer staples), I believe that the whole group is somewhat overvalued. Reynolds with a 4% growth rate and a negative 2% terminal growth rate is worth $33, which is 19% below the market's $41, which discounts a 7% five-year growth rate and 0% terminal growth. My Altria expectation would be a 5.5% growth rate and a negative 1% terminal growth rate, implying a $27 stock. The present $32 price implies an 8% growth rate and 0% change in terminal EPS. Lorillard, with a 6% projected growth rate and 0% change in terminal EPS, should be worth $119. Its present $136 price discounts a 9% five-year growth rate and no change in terminal EPS.

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